Fed policy ‘misstep’ a key risk for 2018

Despite the highly telegraphed nature of the US Federal Reserve’s plans to hike interest rates in 2018, a faster move than markets expect would be a big mistake, says T. Rowe Price.

Speaking in Sydney, T. Rowe Price head of multi-asset solutions Thomas Poullaouec said central banks have been surprising on the downside in recent years – but that could be about to change.

"If we look at the Federal Reserve's ['blue dots'] and other pricing of Fed futures, we see that market participants have lower expectations than what the Fed is anticipating it will do," Mr Poullaouec said.

"So we will be going into a world where if the Fed is really doing what they are saying they will do, that can create a world where yields will move faster and surprise markets."

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>Speaking in Sydney, T. Rowe Price head of multi-asset solutions Thomas Poullaouec said central banks have been surprising on the downside in recent years – but that could be about to change.

"If we look at the Federal Reserve's ['blue dots'] and other pricing of Fed futures, we see that market participants have lower expectations than what the Fed is anticipating it will do," Mr Poullaouec said.

"So we will be going into a world where if the Fed is really doing what they are saying they will do, that can create a world where yields will move faster and surprise markets."

Higher yields could have an adverse effect on companies with high levels of debt, and it could lead to reduced earnings which would hamper stock markets, Mr Poullaouec said.

The chance of a central bank mistake is less likely when it comes to the end of bond buying programs, he said.

The ECB, the Fed and the Bank of Japan have almost US$14 trillion on their balance sheets after a decade of asset purchases. That bond buying is coming to an end (with the exception of Japan), but Mr Poullaouec is not worried that it will cause a crash in the bond market.

"Any time yields reach 2.6 to 3 per cent in the US you have other buyers coming in because they are attracted by the higher yield than they can get in their domestic markets," he said.

"Even though we will have a force that was a natural buyer which is going away [i.e. central banks], there are other buyers that are still there," Mr Poullaouec said.

"Those buyers, namely insurers and pensions funds, need to invest in bonds for their long-term liabilities and they are attracted by the slightly higher coupons than they have available in their domestic markets.

"So it's not so much the buying programs that are prone for policy missteps, it's more the expectation that market participants have on yields which could create a policy misstep."